What You Need to Know About HSAs

Key Takeaways

• An HSA, or health savings account, is a tax-advantaged account that lets you save and pay for medical expenses.
• HSAs are available for people with high-deductible healthcare plans, and the IRS will dictate which plans are eligible.
• An HSA has more restrictions than an FSA in terms of who can have one, but there’s a lot more flexibility in being able to hold on to the HSA and keep those dollars growing for you over time.
• HSAs outrank other tax-advantaged accounts, like IRAs and 401(k)s, in terms of their triple tax benefits, but there are some restrictions on how you can use the money.
• When it comes to saving too much in an HSA, there are some safety valves that people can keep in mind when they reach retirement.
• Not all HSA providers are the same, and investors have options if their employer-sponsored HSA isn’t that great.

What Is an HSA?

Ivanna Hampton: Hi, I’m Ivanna Hampton for Morningstar. Health savings accounts offer a tax-efficient way to save for medical costs. Morningstar analyzes the HSA landscape and rates top providers. Morningstar Inc. senior editor Margaret Giles is here to discuss what you should know about HSAs and how to maximize their tax benefits. Margaret has co-written Morningstar’s Guide to HSAs. Well, Margaret, let’s get right into it. What is an HSA, and how does it work?

Margaret Giles: Absolutely. So, an HSA, or health savings account, is a tax-advantaged account that lets you save and pay for medical expenses. And we can call them qualified medical expenses. And that covers everything from co-pays to medication to even vision and dental. And there are two sides to an HSA. One side is a spending account. And you can think of that as a regular checking account. You can have a debit card to use for your healthcare expenses, or you can reimburse either providers or yourself. The other side is an investing account. Similar to other investing accounts like IRAS or 401(k)s, you put money in and then you can invest those funds to use down the line. And the main thing here is the tax savings, which we’ll get into a little bit later.

Who’s Eligible for an HSA?

Hampton: Who is eligible for HSA?

Giles: HSAs have a limited set of people who are eligible to open or invest in them. It’s worth noting you can have an HSA down the line, and then maybe you’re not eligible to contribute anymore, but you can still own it and use those funds. Basically, they’re available for people with high-deductible healthcare plans, and the IRS will dictate which plans are eligible. And they’re both employer-sponsored plans and ACA marketplace plans. So, if you’re self-employed, you could still potentially have an HSA. A couple of other arrangements, there’s a direct primary care arrangement if you’re in one of those where you basically are paying a provider directly, subject to a limit. Those could also be HSA eligible. And then, lastly, you can’t be a dependent on someone else’s tax return, and you cannot be enrolled in Medicare. So, things to remember, but high level, high-deductible healthcare plan, you’ll likely have an HSA available to you.

HSA vs. FSA

Hampton: How is an HSA different from an FSA, also known as a flexible spending account?

Giles: Right. They’re similar in some ways. I would say the spending account side of a health savings account is similar to a flexible savings account. In that you’re putting money in, you’ve got that tax advantage, and then you’re using it directly to pay for healthcare costs. That is kind of the end of the similarities. There are some key differences that are important to keep in mind. One, HSAs have this whole other investing side, which is a huge benefit that an FSA just doesn’t have. The other is that an HSA is something that you can hold on to regardless of leaving your job or even being unemployed. That is something you own. You can have multiple. An FSA is really only available to you through your employer. So, if you’re self-employed, that is not available to you. You also have this kind of use-it-or-lose-it arrangement.

Essentially, as opposed to funding throughout the year like you do with an HSA, with an FSA, you fund it or decide your funding level upfront. And then that is how much you can put in. And you’re kind of on the hook to spend that money because only a limited amount rolls over into the next year. And so you could potentially lose out on those funds if you don’t have enough healthcare expenses to pay for. So, I would say on the upfront, an HSA has more restrictions on who can have one versus an FSA, but there’s a lot more flexibility on being able to hold on to the HSA and keep those dollars growing for you over time.

How to Maximize the HSA Triple Tax Advantage

Hampton: I often hear about the triple tax benefits of HSAs. Can you talk about what those are, and how can someone maximize them?

Giles: Absolutely. So really, this is the big calling card of an HSA, what makes them a really powerful tool both to cover current healthcare costs, but also save for the future. So, money goes in tax-free, it grows tax-free, and then you can take it out tax-free if you’re paying for qualified medical expenses. That’s the big kind of triple crown of tax benefits. But then the other thing to keep in mind is that in addition to being free from income taxes on the upfront, you’re also free from Medicare and Social Security taxes. That’s kind of a triple tax benefit on its own. When it comes to maximizing the tax benefits of HSAs, it’s really giving yourself time to take advantage of the tax-free growth. And so with that, using the investing account becomes so important because you’re able to grow your dollars over time. And there’s no requirement about when you have to take out that money, and so if you have a long time horizon, I could have this money grow for 40 years and take advantage of all of that tax-free compounding and not have to worry about a tax bill at the end of the day. You still get a little bit of growth on the spending account side. Similar to a checking account, they do pay interest rates, but it’s really marginal compared to what you can get with investing those dollars. So, it really is kind of a time game. Can you keep that money invested over time to take advantage of that growth?

How HSAs Compare to Other Tax-Advantaged Accounts

Hampton: How do HSAs compare to other tax-advantaged accounts like IRAs and 401(k)s?

Giles: Right. In some ways, they’re pretty similar, but HSAs are the only ones that have the triple tax benefit. These other kinds of accounts basically have two out of three. So, if you’re looking at a traditional account, whether that’s a 401(k) or an IRA, that will let you contribute pretax dollars, and then you get that tax-free growth, but then you owe income taxes on the back end when you withdraw in retirement. With a Roth, it’s basically the opposite, where money goes in after tax, but you still get tax-free growth and then tax-free withdrawals. With an HSA, you get all three. And so you’re not owing taxes at any of those points. Another similarity, though, is that there are some penalties that you have to keep in mind with all of these accounts, depending on either the timing or what you’re using the money for. So, with retirement accounts, if you withdraw early before 59 and a half, then you’re going to owe an extra 10% penalty in addition to any potential income tax you might owe if it’s a traditional account. With an HSA, it’s actually more of a penalty. If you withdraw before age 65 and you use it to pay for nonmedical expenses, you’ll owe a 20% penalty. So, HSAs really actually outrank these other accounts in terms of their benefits, but there are some restrictions on how you can use the money.

Can You Save Too Much in an HSA?

Hampton: Now, it may be hard to figure out how much money you’re going to need for medical costs in the future. Is it possible to save too much in the HSA?

Giles: That’s a great question. And I think it could give some people pause when they’re thinking about using an HSA, because on its surface, it’s limited, right? You can only use it for medical expenses. And so you don’t know what you need. However, there are some safety valves that people can keep in mind. So one, when you’re in retirement, you can use your HSA to pay for your Medicare premiums. As you’re in other healthcare plans, you’re not allowed to use the HSA to pay for those premiums unless it’s Cobra or you’ve just been laid off and you’re collecting unemployment. But in retirement, you can. So, that’s your regular Medicare premiums, not the Medicare supplements. That’s Medigap. That’s always going to be a stream of income that you need to cover those premiums.

After that, there are some loopholes. My favorite to talk about is this idea that you can reimburse yourself at any time. So, if you pay for your medical expenses out of pocket, and you save those receipts, I could reimburse myself 30 years down the road. The only rule is that if I’m covering this healthcare cost out of pocket, I need to already have opened the HSA. So, in essence, I know I’ve spent $1,000 on medical costs, but I’ve paid out of pocket. If I need to spend $1,000 on home improvement or some other emergency expense, I can actually reimburse myself from the HSA. And then it can still count as a medical reimbursement because I have those saved receipts. That’s one big one that I think is worth keeping in mind. Otherwise, you also have some more escape valves in retirement. So after age 65, you can use the HSA to pay for any cost. It doesn’t have to be medical. If it’s not a qualified medical expense, then you do have to pay an income tax, but you’re not paying a penalty. So, less restrictions there.

Lastly, I will say, it’s kind of a warning: You don’t want to leave your HSA behind. While it’s highly unlikely that you’re going to have way too much, you do want to make sure you use those dollars. And that’s because if your spouse inherits your HSA from you, they can use it as an HSA. After them, if you have another beneficiary, it stops being an HSA when they inherit. It becomes taxable income to them, and they can no longer have those tax benefits of the HSA. So, a lot of escape valves, but keep in mind, you should use that money.

Can You Switch HSA Providers?

Hampton: HSAs have a lot of great benefits, as you were just describing, but not all HSA providers are the same. What options do you have if your employer-sponsored HSA isn’t that great?

Giles: Right. First and foremost, you can have multiple HSAs at a time. That gives you a little bit of flexibility to take advantage of what a potentially better provider has to offer. There are two main ways that you can move money from one HSA to another. One is a transfer. And this is something that I think is the best route to go because you have some flexibility. You’re basically having your two providers deal with each other directly. So, you can initiate a transfer. One provider will directly send the money to the other. There’s no tax liability when it comes to that transfer. It goes directly, and you can do that as many times as you want. The other option, I think this is more applicable if you want to leave an HSA for good, just because you have some more structure you have to follow, is a rollover. In that case, you’d receive a check from your HSA provider, and then you would deposit in another HSA, and you have to do that within 60 days, or there could be a penalty. And lastly, that’s only allowed once a year. So, I think it really is worth keeping your employer-sponsored HSA, take advantage of maybe employer contributions, and especially the pretax payroll deduction, because you do get to be free from income tax, Social Security, Medicare. But then you do have your options to take advantage of what else is out there.

Hampton: Margaret, thank you for your time today.

Giles: Thanks for having me.